Week 11 Monetary and fiscal policy

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Week 11Monetary and fiscal policy
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Goods market equilibrium

• The goods market is in equilibrium when aggregate
  demand and actual income are equal
• The IS schedule shows the different combinations
  of income and interest rates at which the goods
  market is in equilibrium.

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The IS schedule
AD
45o line
Income
r
Income
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Money market equilibrium

• The money market is in equilibrium when the
  demand for real money balances is equal to the
  supply.
• The LM schedule shows the different combinations
  of income and interest rates at which the money
  market is in equilibrium.

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The LM schedule
r
r
r0
L0
Real money balances
Income
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Shifting IS and LM schedules

• The position of the IS schedule depends upon
• anything (other than interest rates) that shifts
  aggregate demand e.g.
• autonomous investment
• autonomous consumption
• government spending
• The position of the LM schedule depends upon
• money supply
• (the price level)

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Equilibrium in goods and money markets
r
Income
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Fiscal policy in the IS-LM model
Y0, r0 represents the initial equilibrium.
r
LM
r0
?
IS0
Y0
Income
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Fiscal policy in the IS-LM model (2)
Y0, r0 represents the initial equilibrium.
r
LM
r0
?
IS0
Y0
Income
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Monetary policy in the IS-LM model
Y0, r0 represents the initial equilibrium.
r
LM0
?
r0
IS0
Y0
Income
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The policy mix
Demand management is the use of monetary and
fiscal policy to stabilize the level of income
around a high average level.
r
This affects the private public balance of
spending in the economy.
Income
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But...

• The IS-LM model seems to offer government a range
  of options for influencing equilibrium income.
• But
• there are other issues to be considered
• the price level and inflation
• the supply-side of the economy
• the exchange rate

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Aggregate supply, prices and adjustment to
shocks
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The classical model of macroeconomics

• The CLASSICAL model of macroeconomics is the
  polar opposite of the extreme Keynesian model.
• It analyses the economy when wages and prices are
  fully flexible.
• In this model, the economy is always at its
  potential level.

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The classical model of macroeconomics (2)

• Excess demand or supply are rapidly eliminated by
  wage or price changes so that potential output is
  quickly restored
• Monetary and fiscal policy affect prices but have
  no impact on output
• In the short-run before wages and prices have
  adjusted, the Keynesian position is relevant
  whilst the classical model is relevant to the
  long-run

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The macroeconomic demand schedule

• The macroeconomic demand schedule (MDS) shows the
  combinations of inflation and output for which
  aggregate demand equals output.
• Higher inflation is associated with lower
  aggregate demand and lower output.

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Aggregate supply and potential output

• Potential output depends upon
• the level of technology
• the quantities of labour demanded and supplied in
  the long-run, when the labour market is fully
  adjusted
• When wages and prices are fully flexible, output
  is always at the potential level
• In the short-run we can treat potential output as
  given

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The classical aggregate supply schedule

• The classical model has an aggregate supply curve
  which is vertical at potential output
• This means that equilibrium output can be reached
  at different levels of inflation
• In the classical model, people do not suffer from
  money illusion
• Consequently, only changes in real variables
  influence other real variables

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The classical aggregate supply schedule (2)
This schedule shows the output firms wish to
supply at each inflation rate.
AS
Inflation
When wages and prices are flexible, output is
always at its potential level (Y)
Potential output is the economys
long-run equilibrium output.
Y
Output
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The classical aggregate supply schedule (3)

• Better technology will shift AS to the right and
  hence increase potential output
• Increased employment will also shift AS to the
  right and increase potential output
• As will the use of more capital
• In the short-run, we can treat potential output
  as given

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Equilibrium inflation
AS
Inflation
At A, the goods, money and labour markets are all
in equilibrium
Y
Output
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Equilibrium inflation a supply shock
AS0
If the central bank pursues its target of ?0
when the economy is at potential output, it
must respond by reducing its target real interest
rate.
A
?
?0
Inflation
MDS0
Y0
Output
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Equilibrium inflation a demand shock
AS0
A
?
?0
Inflation
Since potential output is the same at B, the bank
must tighten its monetary policy in order to hit
its target of ?0 .
MDS0
Y0
Output
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Supply-side economics

• The pursuit of policies aimed not at increasing
  aggregate demand, but at increasing aggregate
  supply.
• A way of influencing potential output, seen as
  critical in the classical view of the economy.

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Inflation, expectations and credibility
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Inflation is ...

• Inflation is a rise in the price level

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The quantity theory (1)

• The quantity theory of money says
• Changes in the nominal money supply lead to
  equivalent changes in the price level (and money
  wages) but do not have effects on output and
  employment.

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The quantity theory (2)

• We can state it algebraically as
• MV PY
• where V velocity of circulation
• Y potential level of real GDP
• P the price level
• M nominal money supply
• Given constant velocity, if prices adjust to
  maintain real income at the potential level
• an increase in nominal money supply leads to an
  equivalent increase in prices

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Money, prices and inflation (1)

• Milton Friedman famously claimed
• Inflation is always and everywhere a monetary
  phenomenon.
• i.e. it results when money supply grows more
  rapidly than real output.

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Inflation and interest rates

• REAL INTEREST RATE
• Nominal interest rate minus inflation rate

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The Phillips curve
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The long-run Phillips curve (1)

• The vertical long-run Phillips curve implies that
  sooner or later, the economy will return to U
  whatever the inflation rate
• the position of the short-run Phillips curve
  depends on expected inflation

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The long-run Phillips curve (2)

• the long-run and short-run curves intersect when
  actual and expected inflation are equalised
• the long run Phillips curve shows that in the
  long-run there is no trade-off between
  unemployment and inflation

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The Long-run Phillips curve and an increase in
aggregate demand (1)
Inflation
PC1
U
but what happens next?
Unemployment
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The Long-run Phillips curve and an increase in
aggregate demand (2)
If the nominal money supply continues to expand
at the same rate thereafter, the economy will
eventually move to B on PC2.
LRPC
Inflation
At B, inflation expectations coincide with actual
inflation and nominal wages have been
renegotiated so that the real wage and
hence, employment are the same as before the
monetary expansion
A
?2
?1
E
PC2
PC1
U
U1
ie there is no trade- off between unemployment
and inflation in the long-run
Unemployment
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Defeating inflation

• In the long run, inflation will be low if the
  rate of money growth is low.
• The transition from high to low inflation may be
  painful if expectations are slow to adjust.
• Policy credibility may speed the adjustment
  process